The President and the Supremes

By Chandrashekar (Chandra) Tamirisa, (On Twitter) @c_tamirisa

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Checks and balances in action in a well-functioning democracy can be a very interesting sight to watch. The Supreme Court of the United States run by constitutional lawyers is duly critical of the White House also run by a constitutional lawyer. The peers are sparring over the economic substance of social policies being implemented by the White House during the current economic crisis. It almost feels like FDR’s Supreme Court in his first term in office.

The Court quite appropriately ruled that the marketplace must decide the fees charged by mutual funds and that it is difficult to determine what “excessive” is. It is clear that the Court is wary of wage and price controls imposed arbitrarily by the government to deal with Wall Street excesses even as it recognizes the factors such as conflicts of interest that could potentially lead to price gouging by financiers for their services. This case could have an important impact on the future of retirement security and social security reform as well as for financial regulatory reform.

Mutual funds are typically large investment pools which can exert considerable clout on the marketplace when they shift into and out of assets. Given their size, they achieve economies of scale. To a fund manager, the pot is one pile of cash which can give the financial institution substantial leverage in seeking returns. The larger the investment and the better the judgment about risk the larger the return.

The fees fund managers charge to provide their financial services are paid both when consumers sign up, independent of the returns, and also as a share of the returns, depending on the type of the fund. When a fund loses money the fees are still charged out of contributions to the fund. If a fund is contingent in its provisioning of services, it only earns its fees based on its performance with the burden therefore on the need to perform and this could mean higher risk levels. Typically the fund prospectuses provide this information to consumers who then, based on their risk preferences, choose the funds they like to invest with.

In either case ― contingent fees or non-contingent fees ― the fund managers claim a share of the pot of pooled monies. The matter of sharing economies of scale with the contributors to the fund only arises typically when the fees are contingent on performance. Still, the consumers have a choice in a competitive market place unless collusion in fees setting is taking place to limit the choice of consumers and this provides the legal test to judge if the fees are excessive.

A simple survey of all comparable mutual fund fees will give a snapshot of the nature of competition in the market. Consumers, even if the fees are the same, have the choice to shift between funds based on the returns. This means better performing funds in a market where fees are nearly the same are charging less relative to poorly performing fund managers because charging the same fees but returning better yields makes some funds more competitive than the others, giving them the opportunity to increase their economies of scale by drawing away consumers from other funds. A salient example was the Fidelity Magellan Fund which had to turn down new consumers of its services because of its size.

The Court is correct that Fund executives’ compensation cannot be arbitrarily set by the government. As the 7th Circuit Court judge in Chicago had ruled, “judicial price setting” is a bad practice and that transparency is needed in the markets to ensure competition and to safeguard consumer interests and most of it can be achieved through financial regulatory reform.

Still, if financial regulatory reforms cannot prevent the excessive share of national income of the financial markets leading to the rising income disparity in the country which is and should be, quite appropriately, the due concern of the United States Congress (as Associate Justice Alito pointed out) and the White House (and can also be of the Supreme Court should a case come its way arguing that the general welfare of the country is being impaired by poor economic policy making), the government can make amends through the economic policy instruments at its disposal, particularly tax policy to ensure equitable income distribution in the society. After all, the President of the United States earns only 10 times the lowest paid government worker. The private sector can be happy with a multiple of 100.

The problem of executive compensation, both in product and service markets, is the principal cause of the rising income disparity and the poverty rate. If corporate boards do not correct this pornography (as Justice Potter Stewart is known to have famously said, “[you] know it when you see it.”) of their own accord similar to the Motion Picture Association of America, the government will have to intervene and indeed then the debate belongs in the Congress and the White House and not the courts.

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About Chandrashekar (Chandra) Tamirisa

http://www.thecommonera.com/Common_Era/Me.html
This entry was posted in Economics, Financial Regulation, Politics, Supreme Court, Transformations LLC and tagged , . Bookmark the permalink.

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